Friday, February 27, 2009

Yield on Cost Matters

The bear market has brought many stocks to multi-year lows, pushing their current dividend yields to levels not seen for years. Some dividends got cut in the process, triggering further selloffs in stock prices, which somehow miraculously lead to almost the same current dividend yields. Multiplying the most recent quarterly or monthly dividend payments by 4 or 12 and then dividing the result by the amount of the stock price calculates current dividend yield.

For example if you purchased Bank of America (BAC) stock in September 2008 at $25.60, while the dividend was $0.64/quarter, the current dividend yield would have been 10%. After BAC cut its dividends by 50% to $0.32/quarter, if the stock was trading at $12.80 then the current dividend yield would have been 10% as well. Most investors who chase high yielding stocks blindly would tell you that in both situations BAC was a high yielding stock to consider. There is one difference however – the person that purchased BAC for $25.60 is worse off after the dividend cut, in comparison to the investor who purchased BAC stock at $12.80, since their dividend income is decreased in half.
Astute readers would realize that current yield does not matter much to a long-term dividend investor. What matters is that dividend payments get increased over time.

If an investor purchased stock in Bank of America in 2002 at $30/share, their current dividend yield would have been 4%. As Bank of America kept increasing its dividend payments from $0.30 to $0.64, the current yield on Bank of America was almost unchanged around 4%.

The yield on cost however, which is calculated by dividing the most recent annual dividend payment to the price that you paid for the shares that you own, has been increasing despite the current yield being unchanged.

An investor who purchased 100 shares at $30 in 2002 received $30 every quarter. The current yield and the yield on cost in this scenario were 4%. The amount received increased as the dividend payment was raised to $0.64/quarter in 2007, bringing the yield on cost to 8%. The current yield was almost 5% at the time when the dividend was increased and the stock was trading at $50.

When Bank of America cut its dividend payment to $0.32/share current yields were still in the vicinity of 10%. This affected only new investors however, since they were the ones who might generate a 10% annual return on their investment solely from the dividends received, provided that the payment was not cut again. The investor who purchased BAC stock back in 2002 saw their income fall by half, bringing their yield on cost to 4.3%.

In hindsight, selling after the first dividend cut and allocating the money into another dividend growth stock, could have been a good thing for the investor who purchased BAC stock in 2002. As we later learned, Bank of America cut its dividend payment per share once again to just one penny per quarter.
There are many dividend success stories however, where investor’s yield on cost is in the double or even triple digits. An investment in 3M (MMM) at the end of 1988 at $16 generated a current dividend yield as well as yield on cost of 4%. After 20 years of consistent dividend increases however, the annual dividend payment is increased to $2/share, making for a yield on cost of 12.5%. Check out my analysis of MMM.

Even if you purchased into an S&P 500 index fund in the late 1970’s, you would have seen our yield on cost increase from 5.20% to 26.20% currently.

I hope I have illustrated a point that high current yield is not what dividend growth investors should be looking at when they search for investment opportunities. The thing that matters is finding a solid non-cyclical company with a wide moat, which could increase its earnings over time. Increase in earnings power could lead to increase in dividends over time. As Dave Van Knapp put it in 10x10, the best dividend strategy is to achieve a balance between dividend growth and initial dividend yield.

Relevant Articles:

- Don’t chase High Yielding Stocks Blindly
- 10 by 10: A New Way to Look at Yield and Dividend Growth
- Bank of America (BAC) might have to cut dividends
- Bank of America (BAC) Dividend Analysis
- Best CD Rates

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